Research paper IIs illiquidity risk during a market crisis underestimated? Pierre Astolfi, University Paris 1 Arnaud Thauvron, University Paris-Est Créteil Marc Desban, University Paris-Est Créteil Sylvie Lecarpentier-Moyal, University Paris-Est Créteil
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Research paper
IIs illiquidity risk during a market crisis underestimated?
Pierre Astolfi, University Paris 1
Arnaud Thauvron, University Paris-Est Créteil
Marc Desban, University Paris-Est Créteil
Sylvie Lecarpentier-Moyal, University Paris-Est Créteil
er
The views expressed are those of the authors alone.
IIs illiquidity risk during a market crisis underestimated?
Pierre Astolfi, Marc Desban, Sylvie Lecarpentier-Moyal, Arnaud Thauvron
3/31
Abstract
The notion of illiquidity risk is widely described in the literature. However, this risk often seems
to be seen as specific to the asset itself (diversifiable risk requiring no excess return), and not
as systematic risk (market risk requiring a higher return).
We seek to increase our understanding of illiquidity in a major financial crisis using an
exploratory survey of financial analysts and valuation analysts in France. Indeed, not all of the
lessons from the 2008 crisis were learned, leading to a misapprehension of illiquidity risk as a
systematic risk, i.e. a risk that can affect all asset classes by contagion. Therefore, the effects of
extreme scenarios, such as a major financial crisis, are probably underestimated.
IIs illiquidity risk during a market crisis underestimated?
Pierre Astolfi, Marc Desban, Sylvie Lecarpentier-Moyal, Arnaud Thauvron
IIs illiquidity risk during a market crisis underestimated?
Pierre Astolfi, Marc Desban, Sylvie Lecarpentier-Moyal, Arnaud Thauvron
5/31
Preamble
Illiquidity has been the subject of much academic and industry research. The reference model
for financial market operations (Markowitz, 1952) is based on the assumption that invested
assets are liquid, but, in practice, investors incur liquidity risks. Thus, illiquidity is seen as an
undeniable manifestation of a form of market failure.
More specifically, liquidity is the ease with which an asset can be converted into cash. This
notion is linked to the idea of a market, since it brings together supply and demand, even if it is
not necessarily on an organised market. It is represented by the cost of executing a transaction
immediately (Amihud et Mendelson, 1986). This means that liquidity is linked to the notion of
“marketability1”. All else being equal, a liquid asset is more valuable than the same asset if it
is not liquid, since it can be converted into cash quickly and at less cost. The costs arising from
a lack of liquidity may be linked to the discount given to ensure a quick sale, or the time spent
waiting for a buyer. The matter of time is critical, as is often the case in finance.
Generally speaking, illiquidity discounts are found in the following cases:
- when valuing unlisted companies (Hertzel and Smith (1993), Koeplin and al. (2000),
Kooli and al. (2003), Zanni (2013));
- when accounting for restrictions on selling the asset in question, such as contractual lock-
up provisions or a shareholders’ agreement that restricts sales (Johnson (1999), French Tax
Guide (2006), IPEV Guide (2018), tax case law cited in SFEV (2018));
- or when accounting for particular situations, such as listed securities with limited trading
volumes, or during a major financial crisis (Khandani and Lo (2007; 2011), Ang and al.
(2014), Green (2015)).
The scale of the discounts reported varies depending on the research, ranging from about 15 %
(Kooli and al., 2003) to more than 40 % (Emory and al., 2002). Other authors suggest
increasing the discount rate to account for illiquidity, with a wider spread for debt securities
(Green, 2015) or "liquidity betas” (Pastor and Stambaugh, 2003).
According to the literature, illiquidity is seen as linked to either the general state of the market
(making it a parameter of systematic risk) or to the specific characteristics of the company in
question (making it a parameter of idiosyncratic risk).
This is an important distinction, since classical financial theory states that only market risks, or
systematic risks, are likely to be compensated with higher returns. Idiosyncratic risks, or
specific risks, are not compensated with higher returns since they can be eliminated through
diversification.
We shall start by presenting the notion of illiquidity risk, as described in the literature. Then we
shall look at the links between illiquidity and market values, followed by the links between
illiquidity and book values. Finally, we shall present the findings of an exploratory survey
conducted during the second half of 2018.
1 The definition is not the same as for other uses of the term.
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1 The notion of illiquidity
1.1 The principle of illiquidity
In financial theory, the value of an asset is equal to the present value of the cash flows that the
asset is expected to generate in the future, including cash from its resale, where appropriate.
The cash flows calculated in this way are associated with full ownership of the asset. If the cash
from the sale of the asset is temporarily unavailable to the owner, the value of the asset will be
negatively affected. In this case, the owner of the asset is unable to optimise his or her portfolio
allocation by choosing to sell the asset and invest in assets offering higher rates of return or
lower risks.
In other words, illiquidity refers to the level of constraints likely to impede the conversion of a
given asset into cash. The illiquidity constraint may need to be taken into account, even if the
period of illiquidity is short (Longstaff, 1995). In the same way, Barneto and Gregorio (2010)
define illiquidity “as the ease with which an investor can trade a given asset at any time
immediately and at a low cost”.
Therefore, the notion of illiquidity applies to an asset with constraints on its liquidity, compared
to another asset that has all the same characteristics, but is easy to sell. Illiquidity is reflected in
a “Discount for Lack of Marketability” (DLOM) (Zanni, 2013). Nevertheless, the notions of
liquidity and marketability are very similar, but they are not the same. An asset may be traded
on a market, but that market may be inefficient, resulting in illiquidity costs.
Illiquidity may affect shares that are not traded freely on a market (Koeplin and al. (2000),
IPEV Guide (2018)) or, more generally speaking, any assets that cannot be sold freely, such as
real assets (Bajaj and al. 2001). In principle, the notion of illiquidity is simple, but there are
still many questions. In particular, illiquidity may result from idiosyncratic parameters or from
market-related parameters.
1.2 What are the most illiquid assets?
The most common assets can be classified according to their illiquidity. Damodaran (2006a)
proposes the following classification:
Figure 1: classification of assets by liquidity
Most
liquid
Least
liquid
Highly rated
corporate
bonds
Treasury bonds
and bills
Liquid widely held stock in
developed
market
Stock in traded company with
small float
Stock in lightly
traded, OTC or emerging
market
Real
assets
Private business
with control
Private
business
without
control
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A major financial crisis or a short-lived episode of stress could have a significant impact on the
proposed ranking. For example, the outcome of the Brexit referendum in June 2016 had a
negative impact on the liquidity of British real assets, to the point that the latter were poised to
become less liquid than certain unlisted assets (see below).
A major financial crisis or a short-lived episode of stress could have a significant impact on the
proposed ranking. For example, the outcome of the Brexit referendum in June 2016 had a
negative impact on the liquidity of British real assets, to the point that the latter were poised to
become less liquid than certain unlisted assets (see below).
Nevertheless, this classification does show that all assets are not subject to the same liquidity
constraints. This explains why a great deal of the literature focuses on the assets most likely to
be affected by liquidity constraints, such as unlisted assets, or else assets traded on emerging
markets (see Section 2 below).
However, it could be worthwhile (see Section 3 below) to make a distinction between specific
illiquidity parameters (idiosyncratic illiquidity risk) and more systematic illiquidity parameters
(market risk).
2 Illiquidity and market values
2.1 Idiosyncratic parameters
It is generally acknowledged in the literature that the illiquidity of an asset stems from the
characteristics of said asset. With this in mind, the illiquidity risk is basically seen as a specific
or idiosyncratic risk, meaning a diversifiable risk, which, consequently, is unlikely to be
compensated with higher returns.
The most frequently cited characteristic likely to give rise to illiquidity for a given asset is not
being listed on an organised market2.
Not being listed on an active market is generally seen as a major source of illiquidity. All else
being equal, an asset that cannot be sold easily for lack of an active market is less valuable than
an asset that an owner can trade freely on a market.
2.1.1 Illiquidity of equities
a) Illiquiity and unlisted companies
The “private company discount” (PCD), or a "discount for lack of marketability" (DLOM), has
been described by Hertzel and Smith (1993), Koeplin and al. (2000), Bajaj and al. (2001),
Kooli and al. (2003) and, more recently, by Zanni (2013).
Zanni (2013) stressed that the discount stems from the lack of liquidity (or marketability) of
private companies compared to comparable publicly traded companies. It should be specified
at this point that other elements are likely to explain a discount, such as company size.
2 A temporary suspension of trading in a given security could also result in temporary illiquidity.
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In fact, the discount on “private placements”, meaning transactions in private companies, stems
from liquidity constraints, along with other factors, such as company size or greater asymmetry
of information (transaction costs are higher in the case of private companies).
The difficulty comes with establishing statistical models to distinguish between liquidity effects
and the effects of other potential factors determining the private company discount. Researchers
generally compare prices for transactions in private companies with prices for transactions in
publicly traded companies. They conduct “pricing multiple studies” to compare a panel of
comparable companies from the same sectors and of similar size. These studies rely on
regression analysis or matched pairs of companies.
The discount found varies between the pricing multiple studies. Koeplin and al. (2000) finds a
mean discount ranging from 20 % based on the EBITDA multiple to 28 % based on the EBIT
multiple for American private companies. Discounts for non-American private companies
could range from 40 % to 50 % compared with comparable publicly traded companies in the
United States. These findings are in line with those of Kooli and al. (2003), who found a
discount of 17 % to 34 %, depending on the multiple used (revenue or cash flow), as well as
with the findings of Block (2007).
Valuation analysts commonly use these studies to justify the illiquidity discount to be applied
for a given company valuation, particularly in the United States. This objective is consistent
with the statistical approach using a regression model.
And yet, Novak (2014) underlined the statistical weaknesses of the most commonly cited
research, to wit Hertzel and Smith (1993) and Bajaj and al. (2001). Therefore, we need to
remain prudent about the actual predictive capability of such models. In particular, there is still
debate about the models’ capability to distinguish the share of the discount that can be attributed
solely to illiquidity. In addition, the applicability of the models to other time periods than those
in the research has yet to be demonstrated.
b) IPO effect
Another approach to measuring the illiquidity discount examines the price pattern of a security
during specific events, such as IPOs. In this case, the price of a transaction in a private company
that later goes public is compared to the share price of the same company, once it is public.
This is the approach used by such authors as Emory and al. (2002). Emory and al. (2002)
examined 543 pre-IPO deals between 1980 and 2000 (deals taking place less than 5 months
before the company goes public) and found a mean discount of 46 % and a median discount of
47 %.
Their approach is an interesting one, even though it may naturally turn out to be difficult to
obtain publicly available information about deals taking place before an IPO, especially since
the deals have to be recent ones.
c) Illiquidity and maturity
Other research underlines the fact that illiquidity increases with longer maturities. This is the
case for Darolles (2017), Darolles and Roussellet (2017) and Darolles (2018). This is a topical
finding, since many investors seeking higher returns are eager to acquire assets for long-term
investment. But the longer an asset is held, the less liquid it is and the more sensitive it is to
market shocks.
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The authors underline the fact that, in the case of open funds combining liquid and illiquid
assets, the illiquidity associated with long-term assets skews performance analysis. It raises the
question of optimising open fund management.
Trades in long-term assets may be less frequent and volatility information about them is less
readily available. Consequently, fund management models need to consider the illiquidity of
long-term investment assets. The authors also state that fund managers are starting to think
about models that do a better job of capturing liquidity risk.
d) Illiquidity of equity securities depending on the different types of shares issued
Another way to assess the impact of liquidity is to compare the liquidity of different classes of
shares issued by the same company (Damodaran, 2006b, p. 518).
A great deal of research has analysed sales of “restricted securities”, which are securities subject
to specific liquidity constraints. For example, under the terms of SEC Rule 144, restricted
securities:
- must be held for a period of one year before being sold;
- are subject to constraints on sales after the one-year holding period, with limits on the
numbers of securities to be sold.
For example, Johnson (1999) estimated the likely discount on restricted securities in the United
States at approximately 20 % between 1991 and 1995. Johnson's findings are an extension of a
major stream of research: he notes that no fewer than 11 studies were conducted in the United
States in the 30 years from 1966 to 1995. These studies were the work of both academics and
market professionals.
2.1.2 Illiquidity of corporate debt securities
a) Principle of the illiquidity discount for debt securities
Debt securities markets also tend to reveal an illiquidity discount.
As is the case for equity securities, the liquidity of a debt security is the “ability to convert
assets into cash immediately or in a very short time” (M&G Investments, 2014).
This aspect is especially critical for debt securities, since such securities, unlike most equities,
can feature more or less complex structuring that affects their liquidity. The assumption is that
the assets in question are structured to suit the needs of a few categories of qualified investors
with the necessary skills.
The complexity of these assets stems from the fact that the issuers do not group them into
uniform market categories. Therefore, investors are likely to demand a discount to compensate
for this additional constraint.
b) Measuring the illiquidity of debt instruments
According to Chander and Lloyd (2013), illiquidity is generally measured by comparing the
price of an illiquid debt security to a perfectly liquid debt security with comparable
characteristics, such as a debt security traded on a regulated market.
In this case the difficulty in measuring illiquidity stems from the fact that the structured nature
of the instruments described above may make it impossible for the valuation analyst to find
comparable publicly traded assets. Furthermore, according to M&G Investments (2014), the
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illiquidity of a debt instrument cannot be measured on its own. The discount is actually analysed
on a case-by-case basis and generally reflects risk components that are difficult to separate from
each other: illiquidity, along with credit risk and complexity.
Measuring the illiquidity discount on its own does not seem to be a key issue for investors, who
are more concerned with being appropriately rewarded for all of the risks incurred.
2.2 Market parameters
The other way to consider the question is to think that illiquidity also stems from the state of
the market. This changes the nature of illiquidity risk, making it a market risk or a systematic
risk. This is a critical distinction, because of its potential implications for compensating
illiquidity. According to the classic equilibrium capital asset pricing model (CAPM), developed
by Sharpe (1964) and others, only market or systematic risks can be compensated, because they
are non-diversifiable. Specific, or idiosyncratic, risk, on the other hand, can be eliminated
through diversification of asset holdings.
The notion of systematic illiquidity risk refers to emerging markets or else markets under major,
but temporary, stress.
2.2.1 Emerging markets
Researchers are paying more and more attention to illiquidity on emerging markets.
For example, Bekaert and Harvey (2000) and Bekaert and al. (2007) have shown how emerging
market affect the illiquidity discount.
The authors point out that, all else being equal, illiquidity is greater in an environment with
higher systematic, or market, risk, as is the case in emerging markets. In particular, they point
out that this illiquidity is accentuated by factors related to the market itself, such as higher
political risk and weaker legislation in the country concerned.
2.2.2 Illiquidity and market return
Regardless of the specific characteristics of publicly traded companies, financial market activity
may have an impact on liquidity, which means it could affect the value of a given company.
However, the findings for this question vary.
Many authors, continuing in the vein of Amihud and Mendelson (1986), have shown that less
liquid assets offer higher returns (Pastor and Stambaugh, 2003; Ibbotson and al., 2013; Brennan
and al., 2013 or Amihud and al., 2015).
Similarly, Ilmanen (2011), based on a study focusing on the United States between 1990 and
2009, found that the illiquidity discount provided by the seller of an asset compensates and
rewards the buyer’s illiquidity risk. Therefore, a preliminary link between liquidity and
systematic factors (market factors) was proposed.
In more recent research, Borcherding and Stein (2016) looked at publicly traded securities in
the United States between 1990 and 2015. They found that the most liquid securities produced
returns to risk that were significantly higher than comparable less liquid securities. Ang (2014),
on the other hand, tried to quantify the illiquidity discount that the author maintained must be
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provided to reward illiquidity risk. He concluded that the illiquidity discount ranged between
0.7 % and 6 %, depending on the illiquidity of the asset in question.
Meanwhile, Chordia and al. (2001) show that liquidity is strongly correlated to market return
cycles. They highlight the fact that, when market returns are high, liquidity is strong, and vice
versa.
2.2.3 Illiquidity during times of temporary market stress
Furthering the previous research, we can point out that major but temporary stress on financial
markets can also give rise to an illiquidity discount on a broad swath of assets, as a result of
massive flights to liquidity or deleveraging (Khandani and Lo, 2007).
Brunnermeier and Pedersen (2009) have shown that in times of market stress, illiquidity and
the market price for liquidity increase, which is perfectly consistent with market micro structure
theory (O’Hara, 1995).
Khandani and Lo (2011) show that a distinction needs to be drawn between two types of
illiquidity:
- illiquidity affecting certain assets that are less liquid than others and, consequently, need to
provide higher returns;
- illiquidity affecting assets in general when a market is less active, as in the event of a market
shock. The authors point out that this component should be assessed in the same way as a
systematic risk premium.
Even more recently, Ang and al. (2014) looked at how liquidity could be influenced by
considering systematic risk. In particular, they showed how a temporary crisis limited the
arbitraging opportunities available to investors. The authors considered a liquidity crisis that
occurs suddenly, without giving investors time to change their portfolios. The temporary crisis
means that investors are stuck with assets that used to be liquid, but no longer are. In this context,
the illiquidity discount can affect a broad swath of assets. Once again, we see that illiquidity
risk encompasses much more than just specific risk.
In this vein, the impact of illiquidity was highlighted in the value of property funds in the United
Kingdom after the Brexit referendum in 2016. Seven British financial groups decided to
suspend redemption requests from investors in certain property funds. The investors had the
option of selling their shares, but only if they were willing to accept a discount of approximately
25 %.
Moss and Lux (2014) examined publicly traded European property companies between 2002
and 2012. Their findings show that, all else being equal, the most liquid companies trade at a
premium and that the premium has increased substantially since the 2008 crisis. They measured
the premium by comparing the net asset value (NAV) 3 of the companies in question to their
market capitalisation. In other research on the property market, Hill and al. (2012) identified a
positive relationship between the value of a property company and its liquidity, measured by
its cash holdings in this case.
3 The standard indicator used in the property sector.
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Thus, in line with Green (2015), these different research findings and market observations
underpin the idea that liquidity risk must be seen as a market risk (or systematic risk), and not
just as an idiosyncratic risk that is specific to a given security.
2.3 Market pricing of illiquidity
Markets can price illiquidity in various ways.
Damodaran (2006b) sums up the main approaches that can be used:
- Illiquidity can first of all be priced by applying a discount to the value of a liquid asset; this
is the simplest approach to implement, even though the question of the percentage to be
applied remains: the proposed percentages vary greatly from one author to the next (from
17 % to 50 %, see below), making it difficult to use this approach;
- Illiquidity can also be identified by adjusting the discount rate. The first approach applies a
premium to the discount rate to reflect the risk stemming from the illiquidity of an asset.
Once again, this approach runs up against the difficulty of determining the appropriate
percentage to use when calculating the premium to be applied to the discount rate. This is
the case for calculating the spreads applied to debt instruments (Green, 2015). Another
method, proposed by Pastor and Stambaugh (2003), adds a “liquidity beta” parameter when
calculating the cost of equity capital. This beta is used to measure the sensitivity of a
financial asset to a change in market liquidity. According to the authors, the liquidity beta
is equal to 1 for an asset where value is strongly correlated to market liquidity and it is equal
to 0 for an asset where value is not correlated to market liquidity. The value of this approach
is that it can be used to implement portfolio management strategies that diversify assets
according to their liquidity betas and not just their return beta.
Increasing the discount rate is consistent with the findings of Saad and Samet (2017) for the
period from 1985 to 2012 in 52 countries. They show that the implied cost of equity capital for
publicly traded companies increases with illiquidity and even more so during a period of market
stress.
More recently, option models were developed to estimate the discount associated with a lack
of liquidity. They are based on the idea that holding a liquid security is like holding a put option,
which allows the holder to sell a security at a price specified in advance and on a given future
date (Abbott, 2009; Finnerty, 2012). In this case the price of the option is considered the price
of liquidity. But, using these models is complicated since they entail estimating the volatility
of the underlying asset, which is often difficult in the case of an unlisted asset.
3 Illiquidity and book value
Markets consider illiquidity of assets, even though there is still debate about how (see above),
but the question of how illiquidity affects book value remains unanswered. Book value is
different from market value in many ways and warrants more specific treatment of illiquidity
risk.
3.1 Illiquidity and IFRS
The notion of illiquidity risk is addressed in IAS 36. IAS 36.30 stipulates that:
"The following elements shall be reflected in the calculation of an asset’s value in use:
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(a) an estimate of the future cash flows the entity expects to derive from the asset;
(b) expectations about possible variations in the amount or timing of those future cash
flows
(c) the time value of money, represented by the current market risk-free rate of interest;
(d) the price for bearing the uncertainty inherent in the asset; and
(e) other factors, such as illiquidity, that market participants would reflect in pricing the
future cash flow the entity expects to derive from the asset. 4”
This provision of IAS 36 refers to the commonly understood idea that an asset that can easily
and rapidly be traded is more valuable than the same asset that is less liquid. We should point
out that the accounting standard-setters showed strong prescience, since the standard was
published in March 2004, years before the 2008 crisis.
3.2 Illiquidity and book values
The benefits of easily obtainable liquidity measurements became apparent in the 2008 crisis.
Obviously, these measurements vary, depending on the nature of the assets in question. They
may be price ranges for publicly traded assets, or annual trading volume, etc. (Anson, 2010).
3.2.1 Book values and asset types
The question of whether book values should reflect illiquidity effects comes up in times of
financial crisis.
This question is discussed in the report to the French government by Marteau and Morand
(2009).
The authors suggest making a distinction between trading assets and medium- and long-term
assets: illiquidity effects should be recognised when determining the book value of trading
assets, but not for the others.
The authors state that “The book-value amplification of the financial crisis stems precisely from
recognition of the liquidity discount when valuing assets and liabilities that are not held for
trading.”
The authors go on to say that “recognition of liquidity effects on the value of positions that are
not held for trading comes from an error in economic5 analysis.” Fair value analysis relies on
an accounting model that focuses on measuring the entity’s performance.
On this basis, Marteau and Morand (2009) maintain that the question of illiquidity6 must be
broken down into two distinct elements:
- a liquidity discount that affects assets held for trading in general. This discount compensates
for the “risk of not being able to sell the asset at its market price under normal market
conditions” (p. 11). Even under normal market liquidity conditions, an investor might “not
be able to sell the desired quantity at the indicated market price” since the sale of an
excessive quantity could lead to a substantial drop in the market price for the asset in
question. However, this discount does not affect assets that are held for the longer term;
4 Our emphasis 5 Our emphasis 6 According to the authors, these two illiquidity components come on top of the default discount that compensates the “non-repayment risk”
(p. 11). This risk affects all assets to different degrees.
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- a specific discount to compensate for the markets’ “reluctance” towards certain asset
categories (p. 11); this discount, which comes on top of the previous discount, affects only
certain asset categories seen as particularly sensitive to episodes of liquidity stress; once
again, strategic assets, meaning assets that are held for the long run, should not be affected
by this discount (p. 51).
As we shall see later (see Section 4.1), the authors go on to say that, unfortunately, the
“systematic” risk component is not yet recognised in book values.
We could also add that this question about aspects linked specifically to long-term holding of
equity assets is also a matter of concern for standard-setting at the European level. In June 2018,
the European Commission asked EFRAG (EFRAG, 2018) to propose alternatives to measuring
equities at fair value through profit or loss or at fair value through other comprehensive income,
as required by IFRS 9, for financial years starting on or after 1 January 2019 (with the exception
of insurers).
3.2.2 Fair value and illiquidity
Marteau and Morand add that the fair value model imposed by international accounting
standards is not satisfactory in a time of financial crisis.
They assert that the assimilation between fair value and market price is “based on an assumption
about the information efficiency of financial markets developed by the Chicago School at the
end of the nineteen-sixties (Eugene Fama). This principle is obviously applicable for trading
assets (e.g. the trading book), but it is no longer applicable when market liquidity is weak7.
Under such circumstances, fair value is the value of a stock based on prices derived from an
insignificant volume of trades, which is not only wrong with regard to theory, but also no longer
corresponds to the assumptions underlying the efficiency model” (p. 11).
4 Is systematic illiquidity risk underestimated?
4.1 Systematic risk
It is generally acknowledged in the literature that the illiquidity of an asset stems primarily from
the characteristics of said asset (unlisted shares, securities subject to legal or tax restrictions).
Therefore, market participants, market analysts, valuation analysts and others seem to misjudge
or underestimate the valuation risks related to systematic illiquidity in the event of a financial
crisis. And yet, there are many arguments to be made for the systematic nature of illiquidity
risk.
First of all, in 2008, only certain assets saw a total collapse of their liquidity (e.g. some
securitised assets and, more specifically, subprime assets) or a substantial decrease in their
liquidity (e.g. debt securities issued by poorly rated companies). Nevertheless, the impact of
this liquidity crisis spread to all other asset classes by contagion. In the event, liquidity risk
could be seen as having become difficult to diversify, making it more of a systematic risk than
an idiosyncratic risk.
Some authors highlighted this aspect of illiquidity as a market risk (Khandani and Lo, 2007;
Khandani and Lo, 2011; Ang and al., 2014; Green, 2015).
7 Our emphasis
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Marteau and Morand (2009, p. 19) clearly point out that, “the discount is made up of three
distinct elements: a “default” discount, compensating the risk of non-repayment, a “systematic”
illiquidity discount compensating the risk of being unable to sell the position held at the market
price under normal market conditions, and a “specific” discount compensating the risk of
market “reluctance” towards certain asset categories. As of now, “systematic” illiquidity risk is
not considered in book value8, even though an illiquidity risk haircut would probably have
tempered investors’ enthusiasm for some securitisation tranches, which were one of main
sources of the crisis.
Warnings issued by the Bank for International Settlements (BIS) back in 2015 highlighted the
dangers of illiquidity in the event of a financial crisis. In particular, the BIS 9 stressed that a rise
in interest rates or an increase in corporate defaults could affect the liquidity of high-yield bonds,
which are also called “speculative bonds”, leaving many investors “stuck” with their assets.
The impact of the current non-conventional or accommodative monetary policies has also be
cited. The European Central Bank (ECB, 2019) itself expressed its reservations in August 2019,
noting that, “On the one hand we see a prospering asset management industry and growing
financial markets. But on the other hand banks have been reducing the size of their trading
books, partly as a result of stricter regulation. This shift in market forces is not a major issue
when times are good and markets are quiet. But market liquidity can be a bottleneck in times
of stress, when many investors are scrambling to square their positions at the same time. In the
past, banks had the balance sheet capacity to absorb a good deal of the assets on offer. In terms
of market functioning, there are strong indications that this kind of buffering mechanism cannot
be relied upon anymore, at least not to the same extent. Market liquidity may evaporate when
it is needed most.”
In addition to debt assets, equities could also be significantly affected by temporary market
stress caused by an excessively rapid rise in interest rates, as was the case in 2008.
Similarly, real assets such as property are affected. As was mentioned above, the prospect of
Brexit led to a decision by seven British financial groups to suspend redemption requests from
investors in certain property funds in 2016. The investors were offered the option of selling
their shares, but only if they were willing to accept a discount of approximately 25 %.
Systematic illiquidity risk is likely to be underestimated and even misunderstood today, even
though it is one of the major challenges facing issuers and valuation analysts in the coming
years.
Under the circumstances, we sought to understand to what extent finance professionals
concerned with valuation (financial analysts, auditors, valuation analysts, etc.) are:
- aware of the notion of systematic illiquidity risk in the event of a major economic or
financial crisis;
- adroit with measuring this risk.
To conduct this research, we surveyed a population concerned by this issue. We focused on
equity assets in our survey.
8 Our emphasis 9 See the quarterly report published in March 2015.
IIs illiquidity risk during a market crisis underestimated?
Pierre Astolfi, Marc Desban, Sylvie Lecarpentier-Moyal, Arnaud Thauvron
16/31
4.2 Presentation of the survey
The survey took place in the second half of 2018 and 454 financial professionals, academics
and students were questioned. All of the respondents are based in France.
The questionnaire (see appendix) was administered online using the Google Forms platform.
The 454 questionnaires sent out, and followed up by 2 reminders, received 153 responses, for
a response rate of 33.7 %. This is a satisfactory response rate in view of the specific nature of
the questions.
The respondents’ profiles are presented in Table 1, Panels A, B and C. Most of the respondents
are between the ages of 30 and 40 (35.3 %), with a post-graduate degree (70 %), working as
valuation analysts or external auditors (60 %).
4.3 Main findings
The main findings tend to show that the financial professionals involved in valuation are both:
- unaware of the notion of systematic illiquidity risk;
- and unfamiliar with measuring this risk.
4.3.1 Illiquidity and standards
First of all, as regards standards (question 2.1), we found (Table 2, Panel A) that most
respondents (more than 56 %) did not know that IAS 36 deals specifically with illiquidity, even
though this standard guides much of the work done in valuation analysis.
And yet, as stated above, the international accounting standard-setter stipulated that, “The
following elements shall be reflected in the calculation of an asset’s value in use:
(…)(e) other factors, such as illiquidity...”
This means that any valuation that does not consider the effects of illiquidity is not in
compliance with IAS 36.
4.3.2 Context and nature of illiquidity
We also asked the professionals about the contexts where illiquidity risk is more critical and
about the nature of this risk (Question 2.2). The survey shows (Table 2, Panel B) that illiquidity
risk is properly identified when valuing unlisted securities (in more than 61 % of the cases),
even though it may not always be measured properly. We also found (Question 4.2) that in most
cases (more than 62 %), respondents thought that the illiquidity discount was not properly
separated from the size discount, whatever the context (financial statements, M&A or portfolio
management). This means there seems to be some confusion in practice about a matter that is
critical, particularly in the case of small and medium-sized companies.
It should be noted that the illiquidity discount on unlisted securities is consistent with the view
that illiquidity risk is a specific risk, but it cannot account for market liquidity risk in the event
of financial stress.
We also found (Question 2.4) that a broad majority of the respondents (nearly 56 %) think that
illiquidity:
IIs illiquidity risk during a market crisis underestimated?
Pierre Astolfi, Marc Desban, Sylvie Lecarpentier-Moyal, Arnaud Thauvron
17/31
- is both a specific and a systematic risk,
- and not either a specific or a systematic risk.
This means that most respondents seem to misjudge or underestimate the valuation risks
associated with systematic illiquidity in the event of a financial crisis.
Determining whether illiquidity is a systematic or a specific risk is critical for valuation. If
illiquidity is a specific risk it can be eliminated through diversification and will not be
compensated other than by a specific premium or discount for each asset concerned. And yet,
economic or financial crisis and stress are always part of financial and market systems and
models.
The vast majority (more than 80 %) of respondents (Question 3.2) agree with the idea that
illiquidity affects only trading assets and not assets held for the long term, which is consistent
with the position put forward by Marteau and Morand (2009).
4.3.3 Measuring specific illiquidity
Despite the uncertainty about the very notion of illiquidity, we attempted to learn about
measurement practices regarding specific illiquidity (Table 2, Panel C).
Among respondents who think that the most satisfactory approach is to increase the discount
rate (Question 2.8), the majority (42.5 %) say that the increase should be between 2 % and 5 %
for equities and in the absence of economic or financial stress.
Of the other respondents who think, on the contrary, that the most satisfactory approach to
illiquidity is to apply a discount to the valuation obtained, the majority (58 %) say that the
discount should be between 15 % and 40 %. However, the varying sizes of the discounts
suggested by the literature are such that no conclusive pronouncements can be made in this
matter.
Despite everything, the majority of the respondents (62 %) think (Question 3.3) that illiquidity
discounts for publicly traded companies are immaterial and even impossible to implement.
They gave several explanations for this:
- either they think that only certain assets are at risk of total illiquidity (e.g. some securitised
assets, particularly, subprime assets) or very significant illiquidity (e.g. debt securities
issued by poorly rated companies), and that other assets are liquid. And yet, we have seen
(see Section 4.1 above) that the risk of contagion across all asset classes is very real, as was
the case in 2008;
- or else they think that occurrences of the risk are too unlikely to be predicted or even
modelled (distribution tails).
Here again, we seem to see the view of illiquidity as a specific risk is predominant to the
detriment of the systematic view. Valuations do not account for extreme risks correctly.
4.3.4 Summary
In summary, we also attempted to find out whether respondents thought illiquidity was correctly
taken into account in valuation analysis.
Not surprisingly, the majority of respondents thought that valuation analysts do not correctly
perceive or account for the notion of risk associated with the potential illiquidity of assets and
IIs illiquidity risk during a market crisis underestimated?
Pierre Astolfi, Marc Desban, Sylvie Lecarpentier-Moyal, Arnaud Thauvron
18/31
liabilities (see Table 3, Panel A), either in the context of M&A or when preparing financial
statements (Question 4.1). The question still has not been resolved.
Similarly, more than 78 % of the respondents think (Question 4.3) that valuation experts do not
properly take account of market illiquidity risk and that the lessons of the 2008 crisis have not
been learned (see Table 3, Panel A). This is a key point since the 2008 crisis served as a major
reminder to valuation analysts about the importance of the notion of illiquidity (Marteau and
Morand, 2009).
Similarly, the majority of the respondents (more than 71 %) think (Question 4.4) that valuation
analysts only consider the most reasonably possible events (CAPM) without including
extremely rare events as well (Table 3, Panel B). Therefore, the criticism levelled at valuation
methods in 2008 is still valid today.
In summary, valuation analysts probably identify the illiquidity of unlisted securities, even
though they may not really take it into account, but they undoubtedly seriously misjudge
illiquidity arising from exceptional market events in times of severe financial stress. Neither
their minds nor their models seem to address extreme crisis scenarios (distribution tails), such
as the 2008 crisis. In such situations only certain assets are affected by total or substantial
illiquidity, but they drag all other asset classes down with them. In these events, the contagion
effect alters the nature of illiquidity risk: it is no longer a specific risk; it becomes a systematic
risk.
Perhaps the lessons of the last major crisis have not all been learned, unless we consider that
the position of Marteau and Morand (2009) has been implicitly taken on board by all market
participants. This position states that illiquidity is not to be taken into account if assets are held
for the long term.
IIs illiquidity risk during a market crisis underestimated?
Pierre Astolfi, Marc Desban, Sylvie Lecarpentier-Moyal, Arnaud Thauvron
19/31
5 Tables
Table 1 - Respondents’ profiles
Panel A
Respondents’ ages Number Percent Running
total
20 to 30 years 25 16.3 % 16.3 %
30 to 40 years 54 35.3 % 51.6 %
40 to 50 years 49 32.0 % 83.6 %
more than 50 years 25 16.3 % 100.0 %
Total 153 100.0 % -
Panel B
Respondents’ educational attainment Number Percent Running
total
Some university or less 5 3.3 % 3.3 %
Undergraduate degree 18 11.8 % 15.0 %
Master’s degree 107 69.9 % 85.0 %
Doctorate or more 6 3.9 % 88.9 %
Specific degree 17 11.1 % 100.0 %
Total 153 100.0 %
Panel C
Respondents’ positions Number Percent Running
total
Sell side financial analyst 7 4.6 % 4.6 %
Buy side financial analyst 8 5.2 % 9.8 %
Portfolio manager 3 2.0 % 11.8 %
Credit analyst 10 6.5 % 18.3 %
Financial manager 5 3.3 % 21.6 %
External auditor 32 20.9 % 42.5 %
Certified accountant 9 5.9 % 48.4 %
Valuation analyst (consulting firm, investment bank, M&A,
etc.) 59 38.6 % 86.9 %
Teacher 8 5.2 % 92.2 %
Other 12 7.8 % 100.0 %
Total 153 100.0 %
IIs illiquidity risk during a market crisis underestimated?
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20/31
Table 2 - Main findings
Panel A: Illiquidity and standards
Do you think that consideration of illiquidity risk is explicitly stipulated
by: Number Percent
French standards 56 45.5 %
IFRS 67 54.5 %
Total 123 100.0%
Panel B: Context and nature of illiquidity
What do you think is the most important contributing
factor to illiquidity of assets? Number Percent
Running
total
For valuation of private companies 94 61.4 % 61.4 %
For restrictions on selling (e.g. tax constraints) 23 15.0 % 76.5 %
For recognising a situation in which trading volume
is/or could be reduced (for listed assets) 12 7.8 % 84.3 %
Other situations 3 2.0 % 86.3 %
Illiquidity is not considered 21 13.7 % 100.0 %
Total 153 100.0% -
What type of risk do you think illiquidity risk is? Number Percent Running
total
Illiquidity risk must above all be seen as a specific risk
(inherent to the asset) => not compensated 25 16.3 % 16.3 %
Illiquidity risk must be seen as a systematic risk
(market risk) => risk that may be compensated 34 22.2 % 38.6 %
Illiquidity risk must be seen as both specific and
systematic risk => risk that may be compensated, in
part at least.
85 55.6 % 94.1 %
No opinion 9 5.9 % 100.0 %
Other 0 0.0 % 100.0 %
Total 153 100.0% -
IIs illiquidity risk during a market crisis underestimated?
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Valuation analysts properly distinguish the
illiquidity discount from the size discount Yes * Percent No ** Percent Total